Sharia-compliant investing: concepts and opportunities

Speech notes for speech at Conference 2006 of Council for Socially Responsible Investment. KPMG Centre, Auckland

Good afternoon, it is a pleasure to speak to you today. I thank the Council for Socially Responsible Investment for the opportunity to do so.

I am here to speak with you about Sharia-compliant investing. This is a new concept to New Zealand, but this sector, which is worth several hundred billion dollars currently, is accepted and growing in other parts of the world, particularly in North America, Europe and Asia. I am currently engaged in a project for the Ministry of Economic Development related to Sharia-compliant foreign direct investment into New Zealand. There may be a window of opportunity for New Zealand to emerge as an investment location for Sharia-compliant funds. The resulting capital inflow may have the potential to contribute significantly to New Zealand’s economic development.

As this is a new idea for New Zealand, I would like to outline the key concepts and share with you some aspects of our project. But first of all, what is Sharia-compliant investing?

Sharia means the “revealed religious law” of Islam. It has five bases. These consist of two primary, and three secondary, sources. The primary sources are the Qur’an, which is the holy book of Muslims; and the Ahadith, the traditions relating to the deeds and utterances of the Prophet Muhammad (peace be upon him). The three secondary sources are juristic techniques known as: Ijma, which means consensus; Qiyas, which is analogical reasoning; and Ijtihad, or independent juristic reasoning. These techniques are exercised by qualified Islamic jurisprudential scholars.

Sharia governs all aspects of Islamic practice including not only faith and worship, but also the economic, social, political and cultural aspects of Islamic societies. Much of the laws, rules and interpretations of Sharia take into consideration issues of social justice and equity. For example, Islam prescribes a compulsory financial obligation called zakah: this is a wealth obligation to be taken from the wealthy and given to the poor. One of the purposes of zakah described in the Quran is “so that the wealth does not circulate only among your rich folk.” In this context, financial markets should operate to enable both an increase in wealth and economic growth, and also its equitable distribution.

The Islamic law on financial transactions is part of the branch of Sharia known as fiqh al-mu’amala, or the law of human interaction. The general Sharia legal maxim is that a particular activity is permissible unless there is a clear prohibition against it. This is reflected in the law on financial transactions. As you will learn, Sharia-compliant financial services emphasise the ethical, social and religious dimensions of financial transactions to enhance equity and fairness for the general good of society. These services are not limited to commercial banking but also extend into capital markets, insurance and other channels of non-bank financial intermediation.

The main Sharia principles that provide the framework for investment and finance are:

Number 1, risk-sharing: The provider of financial funds and the entrepreneur share business risk in return for shares of profits and losses;Number 2, materiality: a financial transaction needs to have a “material finality”, that is a direct or indirect link to a real economic transaction;Number 3, justice: a financial transaction should not lead to the exploitation of any party to the transaction;Number 4, social responsibility: the financing of activities viewed as sinful and socially irresponsible by Islam are prohibited. These include alcohol; pork and related products; conventional, interest-based financial services; gambling and casinos; pornography and prostitution etc; tobacco; and the weapons and defence industries;Number 5, the prohibition of riba or usury, which is interpreted by Sharia scholars to include a pre-determined interest rate fixed ex ante. Riba has the literal meaning of “an excess” and is defined as an increase or excess which accrues to the owner in an exchange or sale of a commodity, or by virtue of a loan arrangement, without providing equivalent value to the other party;And number 6, the prohibition of gharar or uncertainty: there should be full disclosure of information and the removal of any information asymmetry in a contract. An element of uncertainty is considered a normal phenomenon in the market if it is not excessive and where the effect on the economy and society is considered to be minimal.

It is worthwhile to note that these principles are regarded as being universal, so Sharia-compliant finance and investing are open to participation by all people – regardless of their religious beliefs – on either side of a financial transaction. They key considerations are that the source of the funds, the nature of the business, the form of the contracts and the business’ trading practices, must be Sharia-compliant. This is typically assured by the presence in an institution of a Sharia Supervisory Board made up of qualified Islamic scholars, who are able to advise the institution and offer assurance to its investors and/or depositors.

According to recent estimates, the Sharia-compliant banking industry includes 284 Islamic financial institutions operating in 38 countries and managing over 200 billion US dollars, up from 54 billion US dollars in 1993.

The coverage and extent of Sharia-compliant banking varies significantly, from entirely compliant financial systems such as Iran and Sudan at one end of the spectrum, to countries where conventional and Islamic systems coexist, such as Bahrain, Indonesia, Malaysia, Pakistan, or the United Arab Emirates. Recently, Sharia-compliant finance expanded beyond predominantly Islamic countries to the United Kingdom, Switzerland, Singapore and the United States most notably. These countries, which operate under the paradigm of conventional, interest-based financing have responded to the different characteristics of Sharia-compliant financial institutions and intermediaries by recognising their uniqueness and treating them in a way that accrues to them neither an advantage nor a disadvantage versus conventional institutions in areas such as capital adequacy and prudential and accounting standards. The development of institutions like the Islamic Financial Services Board and the Accounting and Auditing Organisation for Islamic Financial Institutions has also introduced greater harmonisation in the industry.

Additionally, there are a number of dedicated Sharia-compliant equity market indices, such as the Global Dow Jones Islamic Market Index, the FTSE Global Islamic Index Series and the FTSE SGX Shariah Index Series. For an example of the value of these, the market capitalisation of the Global Dow Jones Islamic Market Index was estimated to be 10.65 trillion US dollars in March 2005, and the universe of Sharia-compliant stocks numbered 1942 stocks.

There is another type of Sharia-compliant equity product that I will describe later, known as an Ijarah-sukuk, which is a type of sovereign or corporate bond. 18 sovereign ijarah sukuk totalling 5.6 billion US dollars were issued from 2001 to 2005; and 10 corporate ijarah sukuk were issued over the same period, worth almost 1.6 billion US dollars. These have been issued not only in Islamic countries such as Bahrain, Pakistan and Malaysia, but also by the government of the German state of Saxony-Anholt, which launched a 100-million-euro (or 133 million US dollar) sub-sovereign sukuk – Europe’s first – in September 2004.

In the wake of September 11 and the war in Iraq, many Islamic funds have looked to move away from the United States and British financial markets. According to a Merrill Lynch report, at stake is a considerable portion of the 1.3 trillion US dollars of Islamic funds invested in world financial markets. Therefore the global market for Sharia-compliant, and Islamic funds generally, is large and growing, but unfortunately New Zealand is not a destination for many of these.

This may be due to a lack of awareness among investors of the potential opportunities in New Zealand and uncertainty surrounding the regulatory treatment of Sharia-compliant financial instruments. The Ministry’s project has sought to identify whether any regulatory barriers exist and what changes, if any, will be required to facilitate Sharia-compliant investment into New Zealand. This involved officials from a number of agencies becoming familiar with how Sharia-compliant investment operates.

Most types of trade (buying and selling) are permitted in Sharia. A valid trade is concluded if the seller and buyer exchange an offer and acceptance which specify the object of sale and the price. Any financing conducted through valid trading by mutual consent is permissible. However because of the differences with conventional finance, I will outline for you now the most commonly used contracts in Sharia-compliant finance. These are in two categories, profit and loss sharing and non-profit and loss sharing.

There are two profit-and-loss-sharing modes:

Firstly, a joint venture or musharaka. Under a joint venture or limited liability partnership, two or more partners combine capital and efforts and share in the risk and financial results. This is not a common financing mode among Islamic banks, as the banks are typically not involved with enterprise management;Secondly, trust financing or mudaraba. Trust financing is a partnership comprising a financing partner who contributes capital and a managing partner who contributes knowledge and entrepreneurial skills. The financing partner is not involved in management, which makes this a preferred mode for banks. Profits are shared on a predetermined ratio, although losses are borne by the financing partner only unless caused by the irresponsible behaviour of the managing partner. Trust financing in farming – known as muzar’ah – involves harvest-sharing between the bank and the entrepreneur, and the bank may provide either funds or land.

There are also five non-profit-and-loss sharing modes:

Firstly, mark-up financing or murabaha. Mark-up, or cost-plus, financing is a common form of trade financing. The agreement is between the final buyer and a middleman or trader. The final buyer asks the middleman to buy a certain object for an agreed price, which includes the purchase price, costs of the middleman, and a profit margin. Mark-up and other forms of trade financing are popular instruments among Islamic banks, and account for more than 75% of the financing provided in some cases. Their popularity is due to the short-term nature of the financing, limited risk, and guaranteed profit. Furthermore Sharia allows a buyer to cancel a deal at any time;Secondly, lease and lease purchases, known as ijara and ijara wa iqtina respectively. Under a lease arrangement a product is used for a specified period for a specified amount without taking ownership of the product. Under a lease-purchase arrangement, payments include a portion applied toward the final purchase of the product and ownership is transferred at the end of the lease period;The third non-profit-and-loss-sharing mode is deferred payment sale, or bai’mua’jjal. This allows products to be purchased in instalment payments or in a lump sum at a later date;Fourthly, purchase with deferred delivery or bai’salam or bai’salaf. Under this mode, the buyer pays the full price on the delivery date. This is typically applied to agricultural or manufactured products;The final non-profit-and-loss-sharing mode is that of beneficence loans, known as qard hassana. These are zero-return loans to the needy, with no profit to the lender. Service fees can be charged to cover administrative expenses, but should not be linked to either the loan amount or maturity.

Sharia-compliant capital markets are small but growing and there are two key products – equity and shares and Ijarah-sukuk bonds.

Firstly, ordinary shares and different classes of shares are permissible as they represent ownership in the company proportionate to the shares held, however preferred shares and warrants that promise a definite return to their holders – for example during low profit years – while the same is not available to other shareholders are considered to be incompatible with Sharia. The main Sharia issues pertaining to trade in stocks relate to the business of the company whose stocks are to be traded, the form of the stock or share contract, and the Sharia compatibility of the trading practices relating to those stocks. While some systematic screening by indices has started on the basis of the business, very little work has been done around to the form of the contract and the elimination of Sharia non-compliant trading practices.

Secondly, ijarah-sukuk bonds are instruments for governments and corporate entities to raise funds, particularly for infrastructure and other large-scale projects. In a generic structure there are three parties: the originator or beneficiary of ijarah-sukuk; the Special Purpose Vehicle that is the issuer of ijarah-sukuk; and the investors or sukuk holders. There are various forms of sukuk bonds, but it is beyond the scope of this discussion to detail these.

The Ministry’s research is ongoing and we expect to conclude this shortly, but our findings so far indicate that there are no impediments requiring significant legal or regulatory changes for the operation of these instruments in New Zealand. This is good news both for potential investors and the New Zealand economy, but further efforts may be required to attract investment in New Zealand’s Sharia-compliant investment opportunities. Of immediate interest is the lack of a Sharia-compliant banking facility in New Zealand, which will provide the physical means for transactions to occur. This will be a subject of our attention as we go forward, along with other factors as we seek to realise this opportunity for New Zealand.

I hope this short overview has been of some benefit to you, I thank you for your attention this late in the day and welcome any questions or comments you may have.